Venture investing can be an exciting and challenging game to play. Some startups that show incredible promise go bust while others prove to be real money makers. Take instagram for instance, it’s early investors got 312 times their initial investment in less than 18 months. Not a bad return on investment (ROI), but of course, this is one of the mega home runs. Lots of capital has been lost as well, which is important to note.
While most startups never achieve the Instagram success level, there still are a good number of them that have the potential to provide decent returns. On average, if executed strategically, venture investors should aim to achieve 10x returns on individual investments, but across a portfolio, an internal rate of return (IRR) of 25%. As a small allocation in a balanced portfolio, venture investments can provide that uncorrelated high risk, high reward diversification you won’t find in the public markets. Plus, if you can bring value in addition to capital, investing in early-stage companies can be personally rewarding as there may be opportunities to have an impact on the company’s development and direction.
Investing in early-stage startups is an art and can have a steep learning curve, but instead of trying to do it on your own, it does help to join investing communities like 1000 Angels (a company I co-founded) that offers highly curated and vetted, direct investment opportunities. It takes a lot of the heavy lifting out of venture investing and comes with a support system that has domain expertise.
At an early stage, every investor has their own way of performing due diligence, depending on what matters most to them. For instance, some investors focus more on the legal side, others on the team, market size, competitive landscape, and/or business model. There is no right way to perform due diligence, and I recommend writing down all the important questions that you would need to know in order to feel comfortable making the investment. For instance, your list of questions might include the following:
- How many full time people are on the team?
- Is the team’s background relevant to what the company is doing now?
- Do I trust the founders? What are their big motivations for starting this business?
- What does the competitive landscape look like?
- Is their market size attractive?
- Who can potentially acquire them?
- Does their business model make sense?
- Do they have early indicators that what they are building/offering is something people want?
- Does the team look like they have what it takes to stay in it for the long run?
- Are the legal terms favorable for investors?
- What type of traction do they have so far?
- Are the use of funds being allocated strategically?
- Who else is investing?
- Sign up for the startups product/service if possible and test it out yourself!
It may be advantageous to only invest in what you know and understand to start. There are a myriad of variables to consider when investing in startups, which become even more complex when different industries are involved. For this reason, many venture capital firms specialize in a few core industries that they intimately understand. Pick startups that are related to your professional experience or to one of your main hobbies so that the industry is second nature to you, and you can focus on the nuances that may better indicate the potential for success of the business.
Invest alongside seasoned investors and spend time learning about the founders. At early stages, success is often determined less by the business and more by the visionaries behind it and their drive to succeed.
Things to look for during the due diligence process are:
- Cash flows
- Sound valuations
- Strong founding team
- Path to exit
- Product with traction on the market
- Overall funding needs to execute the grand vision
Valuing startups at an early stage has a number of components involved and we recommend leaving that to more experienced or lead investors, at least until you have a sizeable number of investments under your belt and feel comfortable doing it, but you can find further guidance on valuing a startup on 1000 Angels.
However, the cliff note on how to value a company are as follow:
- Asset valuation (tallying all of the tangible assets of the business)
- Income valuation (price-to-earnings ratios)
- Market approach (based on market demands and other competitor valuations)
- Venture capital method (evaluation the best, worst, and base case scenario for performance and then apply a discount)
- Berkus method
- Risk factor summation method (Bill Payne’s method)
- Scorecard method (hybrid of the berkus method and the market comparison)
If you are looking to invest via a convertible note the typical components that are crucial to know are:
Discount Rate: Discount rate refers to the discount percentage you will get when the company you invested in raises a subsequent round of funding that causes your debt to convert into equity in that round.
Interest Rate: Interest rate refers to the interest you will be accruing [most likely annually] from the time you invest to the time your debt note converts into equity. Instead of receiving a coupon payment, your interest will generally be capitalized into the note.
Cap: A cap refers to the highest valuation your note can possibly convert, which gets triggered when a bone fide round of capital occurs. The discount + cap structure allows investors to both have certainty about the maximum valuation for their investment, and participate at a lower valuation rate if less than the cap.
Say you invested $10K in Startup X on January 1st, 2013, which has convertible note terms giving an 8% interest, 20% discount and a cap of $5 million. In addition, the note specifies that if the company raises more than $1.5million, your debt automatically converts into equity at that round’s valuation. Lastly, the maturity date of that note is January 1st, 2015.
One year (to the day) passes and Startup X raises their next round of capital of $2.5million at a valuation of $6million. What does that mean for you? Your $10K investment now has a nominal value of $10,800 ($10,000 principal plus $800 interest) and typically would convert into equity in one of the two following scenarios, depending on which method of conversion is more favorable to investors:
- Round valuation plus the discount: You would have a discount off of the $6million valuation, which would be $1.2million- therefore, the pre-money valuation for the convert holders would be $4.8million (i.e. below $5million cap and therefore the discount + valuation is more favorable),
- Valuation cap: If the priced round were valued at $7million for instance, the discount would be $1.4million and your note would convert pre-money at $5.6million, but since the note is subject to the $5million valuation cap, the note cap clause would kick-in and convert the holders at a $5million valuation instead.
Ultimately, when you’re evaluating different investment opportunities at a Seed/Series A stage, one of the most important things to consider is the founding team. As an angel investor you are investing in people first, and everything else will come after. Sometimes, the initial company you invested in pivoted to something completely different, and that’s ok. The purpose of startups early on is to find a repeatable and scalable business model. So until that is nailed down, the founding team needs to keep trying different combinations until they hit gold, which can be a long and stressful journey. So having confidence that the founding team will hang in there through the highs and lows is key.